Argument: Corporate tax reform is accretive to US equity market valuations (NYSEARCA:SPY)(NYSEARCA:DIA)(NASDAQ:QQQ) at all top rate reduction levels (though not on a 1-to-1 basis due to increased corporate capital costs), assuming the tax deductibility of interest is maintained.
If interest's tax deductibility is abolished from the corporate tax code, then the top rate will need to be reduced down to 26%-27% in order for the average corporation to reach a breakeven point from the change.
The value of a business is the amount of cash that you can extract from it over its life discounted back to the present. The equity is the residual value remaining after all creditors/debtholders have been paid, and can be calculated as: net income (i.e., earnings) + depreciation and amortization expense (given its non-cash in nature) + changes in working capital - capital expenditures + (debt raised - debt paid)
If taxes are cut from 35% to 20%, this would manifest as a ~23% boost to earnings minus whatever extra interest cost is tacked on (due to the diminishment of the tax deduction that interest provides). Holding everything else constant, stocks go up by 22.8% minus this amount. If the tax rate is slash 20 percentage points, stocks would expect to go up ~31% minus this total.
As a side note, very few companies actually pay the full 35% (or beyond), with the average company paying 22% based on this dataset and 21.7% based on trailing twelve months data, though it depends heavily on the sector. But the proportional effect would still be a boost roughly in proportion to the tax decrease.
However, there is also a "denominator" component to this formula. If tax rates are reduced, this diminishes the incentive to take on debt in the first place, given the tax deductibility of the interest works to effectively reduce borrowing costs. Therefore, debt as a capital source becomes less attractive, raising the corporate costs of capital. So while earnings may expand as a numerator term, the cost of capital (the primary denominator term) also expands as well, diminishing some of the accretive effect of the tax cut.
Eliminating Interest Expense Deductions?
Moreover, there has been some thought given to the idea of eliminating the tax deductibility of interest altogether. There are various pros and cons to this proposal.
In terms of pros, doing away with the tax deductibility of interest would help recoup some of the lost revenue from the corporate tax cut itself. The US is ran a budget deficit of 3.2% of GDP in 2016 and the national debt is at $20 trillion, or 111% of GDP. It would take generations to pay this off, and likely never will. It doesn't necessarily need to be repaid down to $0, but rather maintained in a healthy proportion relative to GDP (60% is an often cited number, but open to debate).
Removing this part of the tax code may also reduce the probability or magnitude of a future recession. Expansions and contractions in the economy are fundamentally motivated by the uptake and repayment or default of debt. If the incentive to borrow is diminished, it may mitigate the volatility in the business cycle both if corporate taxes were lowered and particularly if the interest deductibility of debt were to be eliminated altogether. This could work to clean up corporate balance sheets.
The biggest and most obvious drawback would be the increase in corporate capital costs. Earnings would expand with a tax cut, but diminished incentives to borrow would favor equity issuance at the expense of debt, which would cause these earnings to be discounted back to the present at higher rates. Accordingly, corporate valuations would be adversely impacted, though could be offset depending on the extent of the tax cut.
So there are four scenarios to examine:
1) taxes reduced to 20% (-15%), tax deductibility of interest upheld
2) taxes reduced to 15% (-20%), tax deductibility of interest upheld
3) taxes reduced to 20% (-15%), tax deductibility of interest eliminated
4) taxes reduced to 15% (-20%), tax deductibility of interest eliminated
- Scenario 1
If the nominal corporate tax rate is reduced to 20% and the tax deductibility of interest is upheld, the after-tax cost of corporate debt increases by about 23%. There has been no indication historically that a lowering of corporate tax rates reduces the likelihood or extent of debt issuances.
The top corporate tax rate in 1986 stood at 46% before being dropped to 34% by 1988. In 1993, it was raised to 35%, where it still stands today. Despite the 14-point drop (a massive reform), debt as a percentage of nominal GDP continued to rise during this period, denoting that corporate tax rate as an influence on borrowing demand takes a backseat to other factors, such as business needs, point in the business cycle, and nominal GDP growth.
(Source: Board of Governors of the Federal Reserve System; modeled by fred.stlouisfed.org)
Debt as a percentage of the market value of corporate equities (excluding financials) stood at 37.3% as of the end of Q3 2016. Average corporate debt costs are around 5%, based on a current average corporate credit rating of around BB on the S&P/Fitch scale. If the average effective corporate tax rate is 21.7%, then the effective average interest cost would be 3.92% [5% * (1 - 21.7%)].
If we assume the cost of equity of the market is 7%, this would place the weighted-average cost of capital ("WACC") of the market as a whole at 6.16%. If corporate tax rates are slashed by 15 percentage points (dropped by ~43% overall - [1 - (35%-15%)/35%]), this would place the effective corporate tax rate at 12.4%. The market's WACC would project to expand by 13 basis points to 6.29%, as debt's use as a tax shield would decrease.
Using these inputs and assumptions, I would expect a drop in the tax rate by 15 percentage points (with interest's tax deductibility still in effect) to increase the value of the market by 10.9% overall. The boost to earnings heavily outweighs the increase in corporate debt costs, particularly with borrowing rates as cheap as they are currently.
- Scenario 2
Repeating the above, if the top corporate tax rate in the US were reduced 20 percentage points, the market's WACC would expect to increase 17 bps from baseline. The value of the market would be estimated to increase by 14.5%.
- Scenario 3
For scenarios 3 and 4, the tax deductibility of interest is eliminated. Eliminating this part of the tax code in the baseline case (35% nominal corporate rate) would expand the market's WACC by 30 bps, as it would make debt costs that much more expensive. This would expect to decrease the value of the market by 7.7%.
If the elimination of the tax deductibility of interest were done alongside a drop in the tax rate by 15 percentage points, this would expect to increase the value of the market by 6.1%.
- Scenario 4
Following the same scenario as above, but dropping the corporate tax rate another five percentage points (from a top rate of 35% to 15%), this would project to increase the market's value by 10.8%.
To avoid the dilutive effect of eliminating interest's tax deductibility, if this part of the tax code were repealed the top corporate rate would need to be moved down to at least 26.6%.
The following graphs illustrate both scenarios (interest being tax deductible or non-tax deductible) on a sliding scale, with market appreciation based on the corporate tax cut amount in terms of percentage points:
Reducing the corporate tax rate has a level of bipartisan support and is likely to get done in the current administration. Over the past 15 years, there has been a general trend in developed economies of reducing corporate tax rates and increasing personal tax rates. From a government revenue perspective, this makes sense given that corporate earnings only constitute about 9%-11% of US GDP.
The revenue forgone by reducing nominal rates by 15-20 percentage points would only project to reduce annual government inflows by $150-$250 billion. The extra growth obtained could potentially offset the lost revenue if this corporate capital is invested back into new jobs, initiatives that enhance worker productivity, and/or capital investments generally.
Reducing the nominal rate projects to be accretive to the market at any level so long as interest remains tax deductible. But either way, a drop in the top rate does not provide a 1-for-1 boost to the market given corporate debt costs will increase due to the reduction in the tax shield it provides. If interest is no longer tax deductible altogether, the top rate would need to be reduced to at least 26.6% in order for the market to receive a boost.
How much of the corporate tax break is already priced in? There should be a very high probability that a break from 35% to 20% or 15% is already factored in, but it's impossible to isolate due to other expansionary fiscal measures that the market is pricing in as well, such as deregulatory initiatives, infrastructure spending, and repatriation of overseas cash.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.